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Assessing the Cost of Poor Quality in a Small Business
Nat R Briscoe
Frank M Gryna
INTRODUCTION
The cost of poor quality is the cost that would disappear if no errors or deficiencies existed in the product
provided to customers or in any activities conducted by the firm. The term product includes both
physical goods or services and, thus, we will apply the concept to both manufacturing and service firms.
This paper discusses the cost of poor quality in the small business sector. We will:
Explain the concept and benefits of the cost of poor quality

Present the results of research at four small firms

Provide recommendations on making a cost of poor quality study in a small manufacturing or


service firm.

From the history of applying the concept in medium and large firms, some surprises emerge:
The quality related costs are much larger than are shown in the accounting reports. For most
companies in the manufacturing and service sectors, these costs usually vary from 10 to 30% of
sales revenue or between 25 to 40% of operating expenses. Some of these costs are visible;
some of them are hidden. Such profit leaks help to justify an improvement effort.
Quality costs are not simply the result of factory operations, support operations contribute to the problem
as well.
A large portion of operating costs are the result of poor quality. These costs are normally buried in cost
standards, but they are, in fact, avoidable. While the costs of poor quality are indeed avoidable, until
recently there was no clear responsibility given to reduce these costs. Neither was there any structured
approach for doing so. Frankly, these extra costs were simply passed on to customers. Competition on
quality, however, has changed the picture. It is now possible for customers to receive high quality and low
price simultaneously.
The financial loss due to poor quality is an essential element in knowing where a firm, large or small,
stands on quality. But, three other elements are also important:
A firms standing in the marketplace relative to the competition

The quality culture in the organization

The effectiveness of the collection of activities which are used to achieve quality goals.

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This paper focuses on the cost (financial loss) of poor quality.


TRADITIONAL CATEGORIES OF THE COST OF POOR QUALITY
Many companies summarize the cost of poor quality into four categories:
Internal Failure Costs: These are the costs associated with defects, errors or other forms of deficiencies
prior to the transfer of the product to the external customer. An example of this cost is the expense
incurred in rework activities to correct a product defect.
External Failure Costs: These are costs associated with deficiencies that are found after the product is
delivered to the customer. An example of this is the cost of the action required to correct a customer
complaint.
Appraisal Cost: These are costs incurred to determine the conformance of a product or service to quality
requirements. An example is the physical inspection of a product or the testing of software.
Prevention Costs: These are costs incurred to keep failure or appraisal costs to a minimum. Training
programmes on quality techniques are examples of this type of cost.
These four categories are not the only way to define or summarize the cost of poor quality.
Many practitioners, however, have found these categories helpful and we have, therefore, used them in
conducting this research.
RESEARCH METHODOLOGY
Our intent was to gather information regarding the cost of poor quality from several small businesses. To
this end, we met twice with each firm. In the first visit we discussed the concept with the executives of the
firms. We could then determine the extent of their knowledge of the subject and explain why calculating
this cost might be advantageous to them. Also, this discussion was necessary to obtain approval for a
later meeting with the financial officers of each company. All of the executives were eager to explore
further.
When we met with the chief financial officers of the companies, we attempted to discover whether the
costs of poor quality were currently being captured. If these costs were being determined, we asked what
accounts in the financial records were used. To get this information we summarized the four broad
categories of the cost of poor quality and discussed each with regard to specific financial measures. In
this manner we were able to learn which costs were being captured and what methods were being used
to capture those costs.
DESCRIPTION OF COMPANIES
We interviewed four companies to gather information regarding the cost of poor quality in small
businesses. The companies included two manufacturing concerns and two from the service sector.
The first of the manufacturing companies makes plastic packaging for use in the food industry. Plastic
film on rolls is bonded together to form bags, and these go through a rolling process in which the
customers logo is printed on the outside of the bag. The product is then cut to the specified size. The
company employs from 100-249 employees and has annual sales of between $20 and $50 million.
The second manufacturing company makes electrical surge protectors. The casings for the protectors
are purchased from outside sources and the company makes and assembles the inner components. The
firm employs from 100-200 employees and has annual sales between $2 and $8 million.
The first of the service industries provides computer programming services and prepackaged software.
This company is involved with computer software analysis and the design and development of database
decision system software, employs from 90-110 employees, and has annual sales of approximately $14
million.

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The last company we interviewed is a managed health care services company. This firm acts as an
intermediary between insurance companies and the insured. It employs approximately 500 people and
its annual revenues are between $25 and $50 million.
RESULTS OF THE STUDY
A summary of the research results is presented in Table 1. For each of the four categories of the cost
of poor quality, the table specifies subcategories of cost which the companies reported as applicable
(indicated by an X). In addition, the Yes/No notation refers to the capturing of data: Yes means that the
firm currently records the data; No means that the data is not currently being recorded but could be.

Internal failure costs


In all of the companies interviewed, the subcategory of rework was an applicable cost of poor quality, and
in all cases each company is currently capturing this figure from basic data now recorded. Scrap applied
to three of the four companies, however, one of the service companies is a hybrid, and scrap is tracked in
the manufacturing area of the company. It appears that in the service industries scrap may not apply. All
of the companies answered yes to the area of failure analysis, but none of them is currently capturing
the amount spent in this area (each indicated that this amount could be determined by using time
estimates from time cards and then converting the time data to dollars). We observed no pattern across
firms with respect to the supplier area or 100% sorting (two of the companies indicated that this applied,
two indicated that it did not). The manufacturing companies indicated that they do lower prices because
of a product downgrade and are able to capture this amount; this area did not apply to the service firms.
External Failure Costs
One area applied to all companies, complaint adjustment. None of the firms is currently capturing the
costs in this area, but each company indicated that these charges could be captured. The methods for
estimating the costs varied, but all of the methods are based on some method of determining or collecting
the actual hours spent on the adjustment of complaints. Also, since the companies are small, most of the
complaints are handled by middle or upper level management; these individuals indicated that their time
could be determined through better records of the time and money spent in this area. The other
subcategory that applies to all companies is allowances. Each company indicated that concessions are
made to customers when they accept substandard products. The manufacturing companies are
capturing these costs using data that is currently being recorded; the service companies, however, are
not currently capturing these costs. Both service companies indicated that these costs could be
determined using current data (either penalties charged by the customer or the amount of fees waived
because of the problem encountered).
Table 1: Summary of Categories
Manufacturing 1

Manufacturing 2 Service 1

Service 2

Internal Failure
1

Scrap

Yes

Yes

Yes

Rework

Yes

Yes

Yes

Yes

Analysis

No

No

No

No

Supplier

Yes

N/A

No

No

Sorting

No

Downgrading

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N/A

No

N/A

Yes

Yes

N/A

N/A

N/A

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External Failure
1

Warranty

N/A

No

No

Complaint adjustment

3
4

N/A

No

No

No

Returned material

Yes

Yes

Allowances

Yes

Yes

No

No

N/A

No
N/A

Appraisal
1

Incoming

No

No

No

No

In-process

No

No

No

No

Final

No

No

No

No

Quality audit

No

No

No

No

Equipment test

No

No

No

N/A

Materials & service

N/A

No

No

N/A

Inventory

N/A

No

N/A

N/A

No

No

No

No

No

No

Prevention
1

Quality plan

Products review

No

No

Process plan

No

No

Quality audits

No

No

No

No

Supplier evaluation

No

N/A

No

No

Training

N/A

No

N/A

No

N/A

N/A

- indicates, category applies to company

Yes - indicates, data is currently captured


No - indicates, data is not currently captured but could be
Appraisal Costs
Incoming inspection and testing, in-process inspection and testing, final inspection and testing, and
product quality audits apply to all of the companies surveyed. However, none of the companies are
currently capturing these costs. All companies indicated that these costs could be determined if their
labour reporting was more specific, ie, if time cards were used for each individual action performed by
employees. This is a pervasive theme throughout this analysis; the use of more definitive labour
reporting would allow most of the costs of poor quality to be captured and dollarized. None of the other

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areas of appraisal applies to all of the companies interviewed nor is there any pattern such as yes for
manufacturing and no for service.
Prevention Costs
The areas that apply to all of the companies are: quality planning, new products review, and quality
audits. All companies indicated that these costs are not currently being captured but could be. Once
again, the overriding factor seems to be that more efficient use of time cards would serve as a means of
determining the costs in these areas. No pattern is evident in the other areas in this category.
OVERVIEW
Two themes seem to be basic to all of the companies. First, since the firms are small, a great many
quality problems are handled by management, often without understanding the extra costs incurred
throughout the honeycomb of the firm. Each company indicated in its own way that the costs of
correcting problems could be captured if the individuals involved would keep records of the costs incurred
in solving problems and pacifying customers. The other area that is pervasive across companies is that
the other costs of poor quality that apply but are not being captured could be captured or estimated
through the use of some sort of time capturing device, ie, time cards indicating the amount of time spent
on specific areas of inspection, testing, etc. Also, again since the companies are small, management is
able in all cases to talk out problems with one another. The time spent solving problems is also a cost of
poor quality. This cost could also be estimated from meeting minutes, better record keeping on the part
of the individuals involved, etc.
THE IMPACT OF QUALITY ON SALES REVENUE
Traditionally the measurement of the cost of poor quality focuses on the costs of non-conformities, ie,
defects or errors in the goods or services delivered to external or internal customers (the external and
internal failure costs). An important cost that is not usually measured is lost sales due to poor quality.
This is referred to as a hidden cost, because it has not been measured. These lost sales are due to
customer dissatisfaction with the goods or services provided. This dissatisfaction results in a loss of
current customers - customer defections - and an inability to attract new customers because of a
tarnished quality reputation. This loss is difficult to measure, although, if sufficient market research
information is available, it can sometimes be used with other information to estimate the loss of sales
revenue due to poor quality (see Juran and Gryna, 1993, pp. 518-520). In any event, the impact of
quality on sales revenue should be considered at least by identifying the areas of customer dissatisfaction
and taking action to improve retention of current customers and creating new customers.
RECOMMENDATIONS FOR MAKING AN INITIAL STUDY
One approach follows these steps:
In monetary terms, introduce management to whatever data are available. The effect will be to
indicate how big the problem potentially is in terms that will get their attention.

Propose that a committee be formed to gauge the cost of poor quality. Ideally, someone from
management should chair this committee and it should include additional personnel from
accounting and major line functions.

Adapt the categories comprising the costs of poor quality (using the literature) to fit the firm. This
list can be prepared by a quality manager or a finance manager with inputs from accounting and
other functions.

Have upper level management affirm the definitions and assign duties based on these definitions,
including an agenda for data collection.

Collect, summarize and analyze the data. The analysis should identify the vital few areas of the
cost of poor quality. Specific improvement projects should then be proposed to determine and
remove the root causes.

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Select one improvement project and pursue it using the modern problem solving tools of quality
improvement (for a detailed approach see Juran, 1988, Section 22). This first project should be
carefully selected to learn and demonstrate the effectiveness of the problem solving tools.

Review the full study and select additional improvement projects to pursue.

This approach provides an opportunity for upper management to demonstrate leadership on quality, and
it also assures the involvement of functions so that the study receives priority and the results are
recognized as credible.
In defining the costs of poor quality, the following points should be kept in mind:
Customize the definition for your own organization. The failure, appraisal, and prevention
categories presented here have proven useful in practice, but that framework is certainly not
required. As a possible starting point use that framework along with the subcategories reported
in this paper for a manufacturing or a service firm. Review some of the references for additional
subcategories that may apply to your organization. Create a draft of the definition of categories
and show it to various functions asking their input on additional categories or changes in wording.
What results from all this is the right definition for your firm. Whether this definition conforms to
the literature is not critical.

Obtain agreement of the executive management team on the categories of cost to be included
before any data are collected. Sometimes, summarized data on one or two key categories such
as scrap and rework can gain managements attention and stimulate the need for a full study.
The accountant could be asked to review this paper and other literature to prepare a draft of a
definition of categories. The executive team could then review and discuss the draft and finalize
the definition. References that provide detail on preparing a list of categories include Atkinson, et
al (1994), Campanella (1990), Juran (1988), and Morse, et al (1987).

Dont limit the definition to only costs that directly involve the goods or services sold to customers
(eg, scrap, complaints, rework). Poor quality is now viewed as applying to any activity in the
company. Any work that must be discarded or reprocessed should be viewed as a cost of poor
quality. Thus, when information is missing from a document, the time spent in retrieving the
missing information contributes to the cost of poor quality.

Dont accept as inevitable certain camouflaged costs that are routinely incurred but are really part
of the cost of poor quality. In manufacturing, examples are, costs of redesigning a product
because it fails to meet customer needs, or costs of changing processes because they are unable
to meet product specifications. In the service sector, watch for activities that are described with
words like rework, check, expedite, correct, adjustment and shrinkage.

Focus on the internal failure and external failure cost categories because these provide the major
opportunity for the removal of causes of customer dissatisfaction and reduction in costs due to
poor quality. These costs should be attacked first - thats where the money is. Determining the
root causes and removing them will require some level of diagnosis, but the investment of time
and resources in diagnosis achieves a benefit to cost ratio of between 5 to 1 and 10 to 1.
Appraisal costs are also an area for potential reduction but not until the causes of the failure costs
have been identified and removed thereby reducing the need for appraisal.

In the initial study cost data is collected from different sources:


Established accounts: Examples are scrap or rework accounts that quantify the costs incurred in
these areas and price reductions due to product downgrades.

Analysis of ingredients of established accounts: Check to make sure that only the costs of poor
quality are included in the analysis. For example, customer returns will probably include returns
for reasons other than product defects. These should not be quantified in the analysis. It may be
necessary to view the source documents to determine the reason for the return.

Basic accounting documents: For example, inspection costs incurred in the operations area could
be quantified by obtaining the names and the associated payroll data of the employees
responsible.

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Estimates: Several approaches may be needed:

Temporary records: For example, some production workers spend part of their time
repairing defective product. Time keeping devices could be used to establish
temporary records to capture costs incurred to repair defective products. These
could then help to estimate total repair costs.

Work sampling: This random sampling approach determines the percentage of time
spent in each of a number of predefined tasks. This percentage could then lead to
an estimate of the costs incurred in these areas.

Allocation of total resources: For example, in the shipping department, part of the
employees time is spent on inspecting before packaging the product. There may be,
however, no provision for capturing this cost. To quantify this time and cost, ask
each employee to make an estimate of time spent on inspection while packaging the
product.

Unit cost data: Determine the cost of correcting a single error. This cost can then be
multiplied by the estimated number of errors of the same type that are expected per
year. Examples include billing errors and scrap.

BENEFITS OF ESTIMATING THE COST OF POOR QUALITY


Experience has identified the main benefits which lead companies to initiate programs that evaluate
quality costs. The primary benefits are:
Quantify the size of the quality problem in a language that will have impact on upper
management: The language of money improves communication between middle managers and
upper managers. Typically, when the study is made, upper level managers are surprised by two
results. First, the quality costs are higher than expected. Second, problems not previously
recognized are revealed.

Identify major opportunities for cost reductions: A major by-product of evaluation of cost is
identification of costs of specific segments, each traceable to some specific cause.

Identify opportunities for reducing customer dissatisfaction and associated threats to product
salability: Some costs of poor quality are the result of product failures which takes place after the
sale. Analysis of the manufacturers costs, supplemented by marketing research, can identify the
vital few areas of high costs. These areas then lead to problem identification.

Provide a means of measuring the result of quality improvement activities instituted to achieve the
opportunities in 2 and 3 above: Measuring progress helps to keep a focus on improvement and
also spotlights any lack of progress that requires removal of obstacles to improvement.

Align quality goals with organization goals: Measuring the cost of poor quality is one of the four
key inputs for assessing the current status of quality. Knowing the cost of poor quality (and the
other elements) leads to the development of a quality action plan consistent with overall strategic
organizational goals. Deployment of strategic quality goals includes specific quality improvement
and quality planning projects to pursue the opportunities in 2 and 3 above. These projects
become the link between strategic goals and day-to-day quality activities.

Addressing these issues can help to improve retention of current customers and creation of new
customers through new product development. The effort required to make the cost of poor quality study
is more than justified by the benefits listed.
REPORTING ON THE COST OF POOR QUALITY
Reporting on the cost of poor quality can take three forms: (1) special reports to support activities on
quality improvement projects, (2) periodic reports to summarize current status on selected elements of the
cost of poor quality, and (3) comprehensive reports similar to the initial study described in this paper.

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As structured quality improvement teams employing the project-by-project approach have emerged as a
strong force, reporting on the cost of poor quality has focused on supporting activities for quality
improvement projects. These reports should include information to help diagnose the problem and
information to track the change in costs as a problem solving remedy is implemented. Teams may need
narrowly focused information and may be only once. What data is needed is determined by the team,
and the team often collects its own data.
Although some companies have used a quality cost score board to periodically give the status of key
elements of the cost of poor quality, the likely trend is for the cost of poor quality and other quality related
information to become integrated into the overall performance reporting system of organizations. A
limited number of measures would be reported including the cost of poor quality and any information on
the impact of quality on sales revenue.
Table 2: Measures for Relating Cost of Poor Quality
1. Per cent of sales revenue
2. Per cent of profit
3. Dollars per share of common stock
4. Dollars as a per cent of cost of goods sold
5. Dollars as a per cent of total manufacturing cost
6. Dollars as a per cent of standard manufacturing cost dollars
7. Dollars as a per cent of value added dollars
8. Dollars per direct labour hour
9. Dollars per direct labour dollar
10. Dollars per unit of product.
Periodically, say annually, a comprehensive report on the cost of poor quality is useful to summarize and
consolidate the efforts and results of project teams and other quality improvement activities. Such a report
should (1) reflect the results of improvement efforts and (2) provide guidance to identify major areas for
future improvement efforts.
Additionally, the report should be expressed in terms that are meaningful to management. The cost of
poor quality can be related to several other measures. For example, the list in Table 2 provides a sample
of what measures might be used.
What comparative measure is used will determine the effect that the results of the study will have on the
attitude of management. The executives we interviewed thought that costs as a per cent of sales
revenue, as a per cent of profit and as dollars per unit of product produced were meaningful measures.
CONCLUSIONS
Several promising conclusions emerge from this research.
First, small firms can estimate the cost of poor quality easier than large firms. The smaller number of
personnel and fewer lines of communication in small firms make it easier to trace and determine costs of
events that lead to poor quality.
Second, analyzing the components of the cost of poor quality spotlights where most of this loss exists
and, thus, defines the areas where improvement efforts should be focused to improve quality and reduce
the extra costs of poor quality.
Finally, addressing the major contributors to the cost of poor quality by finding and eliminating the root
causes furnishes a golden opportunity for a firm to provide customers with better value. All firms claim

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these days to have products with the best value, but this claim can be made tangible by using the
savings in the cost of poor quality (achieved by a quality improvement effort) to: (1) finance additional
product features without raising prices or (2) lower prices for products with existing features. Either route
to increased value will, of course, lead to higher sales income for the firm.
For many firms, estimating the cost of poor quality can be the catalyst to fuel action-oriented steps to
achieve quality improvement.

SELECTED REFERENCES
1. Atkinson, Hawley, John Hamburg, and Christopher Ittner (1994). Linking Quality to Profits. Institute of
Management Accountants. Montvale, NJ.
2.

Campanella, Jack (Editor) (1990). Principles of Quality Costs, Second Edition. American Society for
Quality Control. Milwaukee, WI.

3.

Juran, J M and Frank M Gryna (1993). Quality Planning and Analysis, 3rd Edition. McGraw-Hill Book
Company. New York.

4.

Juran, J M (Editor-in-Chief) and Frank M Gryna (Associate Editor) (1988). Jurans Quality Control
Handbook, Fourth Edition. McGraw-Hill Book Company. New York.

5.

Morse, Wayne J, Harold P Roth, and Kay M Poston (1987). Measuring, Planning, and Controlling
Quality Costs. Institute of Management Accountants, Montvale, NJ.

6.

Nat R Briscoe

Nat R Briscoe, CPA is an Associate Professor of Accounting at Northwestern State University of Louisiana, in
Natchitoches, LA. He earned a Bachlor's Degree from Memphis State University and received a Master's and
Doctorate from Florida State University.

Frank M Gryna, PhD is Distinguished University Professor of Management at The University of Tampa, Florida. He
previously served as Senior Vice President of Juran Institute. His degrees are in Industrial Engineering from New
York University and the University of Iowa.

This article was specially written for Qimpro Quarterly. It is reproduced here with the permission of the Quarterly.

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